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8 Box 2. Mozambique 2009 FSAP Update—Key Recommendations Measure Timeframe* Access to Finance Standardize bank fees, regularly consolidate and publish fee information Expand coverage and range of information collected by the credit registry, ensure legal framework allows private credit registries Short term Computerize and improve efficiency of property registry Review and improve transparency of court fee structure Enact financial reporting legislation covering regulatory aspects of accounting and auditing Medium Rationalize the regulatory framework for microfinance and develop a capacity building strategy term Discourage bundling of services by banks Banking System Soundness and Supervision Monitor international exposures and encourage banks to develop a stress testing framework Improve loan classification and provisioning rules and review banks’ impaired loan models Short term Introduce remedial action program Issue guidelines for banks on integrated risk management and supervision by risk Regulate and/or develop guidance on interest rate, country, liquidity, and market risk Strengthen crisis preparedness, including internal procedures on emergency liquidity assistance Ensure legal framework allows for flexible resolution tools, including partial purchase and Medium assumption or a bridge bank term Introduce deposit insurance after all preconditions are in place Strengthen cross-border collaboration with home country supervisors Money and Debt Markets and Liquidity Management Use overnight repos and reverse repos for BM short-term liquidity intervention Collateralize standing overnight deposit facility Short term Extend horizon of liquidity forecast to one year Increase stock of outstanding OTs through regular auctions; start issuing fixed rate OTs Medium Issue fungible BTs and OTs and reduce number of outstanding maturities term Pensions and Insurance Improve INSS governance through introduction of an IT system, publication of financial statements, and assessment of the value of investment portfolio Short term Publish outstanding regulations for all pension providers Test adequacy of financial resources, shareholders, and business plans of insurance companies Conduct actuarial study of INSS to determine whether parametric changes are necessary Adopt an explicit investment policy for INSS Medium Subject INSS and other pension providers to independent supervision term Improve frequency and coverage of data collected by IGS Payment System Complete the implementation of RTGS and monitor risks in the CEL Establish a payment system oversight framework Short term Introduce interoperability of cards and promote infrastructure sharing in retail payments Strengthen the staffing in the Payment System Unit Medium Establish rules for mobile financial services provision, especially payments term * Short term: up to 12 months; medium term: 1–5 years. ©International Monetary Fund. Not for Redistribution 9 I. MACROECONOMIC CONTEXT AND MACRO-FINANCIAL LINKAGES 10. Mozambique’s economy is rich in natural resources, which are the main source of export earnings. A large aluminum smelter is Mozambique’s main exporter, accounting for almost half of total receipts, as well as a substantial portion of imports. Other important exports are electricity, gas, cotton, tobacco, and shrimp. Despite the importance of these sectors for foreign exchange inflows (both exports and foreign direct investment (FDI)), the linkages between the large exporters and the domestic economy are still relatively limited. 11. Since the 2003 FSAP, Mozambique’s economic performance has been strong. Macroeconomic stability, sustained structural reforms, substantial foreign aid flows and, until recently, a benign international environment generated an average annual real GDP growth rate of 7½ percent for most of the past decade. Although headline inflation was relatively high and volatile, underlying inflationary pressures were contained Table 1. The trade deficit has been high (with a spike in 2008 reflecting the world oil prices), but consistent with Mozambique’s stage of development and financed by non debt-creating capital inflows. Table 1. Mozambique: Selected Macroeconomic Indicators, 2002–08 2002 2003 2004 2005 2006 2007 2008 Act. Act. Act. Act. Act. Act. Est. Real GDP Growth 9.2 6.5 7.9 8.4 8.7 7.0 6.8 CPI end-of-period, percent change 9.1 13.8 9.1 11.2 9.4 10.3 6.2 Current account balance, before grants, percent of GDP -19.2 -20.4 -14.6 -16.8 -15.4 -15.9 -20.4 Total net aid, percent of GDP 15.1 13.9 11.9 8.2 12.8 13.0 14.0 Private capital inflows, percent of GDP 19.1 7.7 2.7 2.6 2.7 5.7 4.0 of which: Foreign direct investment, percent of GDP 9.0 7.3 4.3 1.6 2.1 5.3 5.9 Gross international reserves, US$ million 825 947 1160 1103 1241 1520 1660 Months of import coverage 5.4 5.4 5.8 4.6 4.4 5.0 4.7 Percent of short-term liabilities 396 401 375 405 57 132 364 Broad money (M3), percent of GDP 27.3 32.4 26.6 28.6 29.7 32.4 33.7 of which: Currency outside banks, percent of GDP 3.5 4.3 4.1 4.0 4.0 4.3 4.0 Private sector credit, stock, percent of GDP 12.9 12.7 9.4 11.8 13.1 13.3 18.2 Foreign currency deposits, percent of total deposits 46.7 45.0 40.1 42.1 40.3 41.8 37.7 Foreign currency credit, percent of total private sector credit 45.9 56.3 58.4 46.7 29.3 24.4 31.6 Source: Mozambican authorities and IMF staff estimates and projections. 12. This performance largely reflects a prudent and successful macroeconomic strategy. Fiscal policy has focused on supporting priority social spending, maintaining debt sustainability, and limiting domestic borrowing in order to avoid crowding out the private sector. Monetary policy has been oriented toward price stability through reserve money targeting in the context of a relatively flexible exchange rate regime. Improvements in monetary management have helped reduce high and volatile real interest rates (identified as a major vulnerability in the 2003 FSAP), while foreign exchange rate operations sought similarly to limit excess exchange rate volatility. Development of the financial sector has advanced in line with a comprehensive financial sector strategy largely based on the 2003 FSAP recommendations.1 These policies have garnered substantial donor support and FDI. 1 The authorities, in collaboration with the World Bank, IMF, and donors, developed a comprehensive program supported by the Financial Sector Technical Assistance Project (FSTAP), a five-year project aimed at strengthening several aspects of the financial sector. ©International Monetary Fund. Not for Redistribution 10 13. Recently, however, the global financial turmoil has clouded the economic outlook and increased macro-financial risks. Box 3 discusses the possible transmission channels from the global turmoil to the domestic economy and financial sector and provides a prima facie assessment of the risks, pending the more detailed analysis in Section III. In summary, the Mozambican financial sector does not seem vulnerable to market and liquidity risks through direct financial linkages. However, given its reliance on commodity exports and external financing, the economy is now exposed to significant risk through real sector linkages. Lower growth in developed economies could affect Mozambique not only through lower external demand but also through declines in FDI and external aid flows, all of which would dampen growth prospects and increase credit risks for banks. Box 3. The Global Financial Turmoil and Mozambique The crisis could affect a financial sector like Mozambique’s through two major transmission channels: Financial sector linkages (i.e., market risk, liquidity risk, and counterparty credit risk) ● Direct exposure of local banks to securities losses or to illiquid asset and funding markets. ● Exposure to counterparties’ with severe losses or illiquidity. ● Sudden stop of capital inflows, with repercussions for bank liquidity and market risk exposures. ● Contagion through parent banks' balance sheets (e.g., impairment of assets held with parents). ● Confidence shock to domestic depositors following bad news about a parent bank or of financial protectionism abroad (e.g., blanket guarantee of deposits in the developed markets). Real sector linkages (i.e., loan portfolio credit risk) ● Domestic borrowers default due to a decline in income caused by a drop in external demand and/or in export commodity prices. ● Domestic borrowers default due to a sudden stop of capital flows and its impact on income, liquidity, interest rates, and exchange rates. In the case of Mozambique, exposure to risk through direct financial linkages is low. Direct liquidity risk is limited, as domestic deposits account for more than 90 percent of liabilities for most banks and liquid assets cover more than 50 percent of deposits. Direct market and counterparty risks are also low, as banks’ securities portfolios are concentrated in treasury bills and deposits with their parent banks, which were not directly affected by the subprime crisis. The long position in foreign currency for the system as a whole and strict limits on net open positions for banks (less than 20 percent of own funds) protect against direct foreign exchange risk, while high provisioning requirements on lending in foreign currency to non-exporters limit indirect foreign exchange risk. And interest rate risk is limited by the preponderance of short-term and floating rate exposures. The only possible exception is the risk of financial contagion from banks’ exposure to parents which, while very low, cannot be entirely ruled out. Foreign-bank subsidiaries in Mozambique have substantial foreign assets invested with their parent or related correspondent banks. Contagion from weak parent banks could take the form of direct pressures to transfer liquidity, or a rumor about a weak parent sparking a loss of confidence. These contagion channels, however, are constrained by capital controls and the current financial strength of parent banks, while associated risks are mitigated by the banks’ high level of liquidity. Furthermore, the BM’s gross international reserves far exceed banking system foreign currency deposits.

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